Solution manual auditing and services 2e by louwers chap004

Financial information prepared by the prospective client: Annual reports to shareholders Interim financial statements Securities registration statements Annual report on SEC Form 10-K Re

CHAPTER 4

Engagement Planning

LEARNING OBJECTIVES

ReviewCheckpoints

Exercises, Problems and Simulations

1 List and describe the activities that auditors

undertake before beginning an engagement 1, 2, 3, 4 53, 54, 55, 65

2 Identify the procedures and sources of information

auditors may use to obtain knowledge of a client’s

business and industry

5, 6, 7, 8, 9 52, 56, 59, 63, 64

3 Perform analytical procedures to identify potential

4 List and discuss matters of planning that auditors

should consider for clients who use computers, and

describe how a computer can be used as an audit

SOLUTIONS FOR REVIEW CHECKPOINTS

4.1 Auditors can use the following sources of information to help decide whether to accept a new audit

client

Financial information prepared by the prospective client:

Annual reports to shareholders

Interim financial statements

Securities registration statements

Annual report on SEC Form 10-K

Reports to regulatory agencies

Inquiries directed to the prospect’s business associates:

Banker

Legal counsel

Underwriter

Other persons, e.g., customers, suppliers

Predecessor auditor, if any, communication, re:

Integrity of management, Disagreements with management

Analysis:

Special or unusual risk related to the prospect

Need for special skills (e.g., computer or industry expertise)

Internal search for relationships that would compromise independence

Auditors can search business press articles and stories and legal files on the Lexis-Nexis system or

on the Internet for news about chairman of the board, the CEO, the CFO, and oftentimes other high-ranking officers Auditors can engage an outside search firm (private investigators) to conductadditional searches for information Auditors are looking for information about client risk factors companies accused of fraud, companies under SEC or other regulatory investigation, companies that have changed auditors frequently, and companies showing recent losses

4.2 Client consent is required because the Code of Professional Conduct prohibits the predecessor

audit firm from revealing confidential information to the successor audit firm without the consent Confidentiality remains even when the auditor-client relationship ends

A successor audit firm should inquire specifically about:

 Management’s integrity

 Disagreements the predecessor may have had with management about accounting principles

and audit procedures

 Communications the predecessor gave the former client about fraud, illegal acts, and internal

control recommendations

 The predecessor’s understanding about the reasons for the change of auditors (particularly

about the predecessor’s termination)

4.3 Engagement letter benefits:

 Helps establish an understanding between client and public accounting firm of the terms of

the engagement and the nature of the work

 Helps avoid quarrels and misunderstandings between client and auditor

 Helps avoid disputes over the audit fee

 Helps avoid legal liability assertions based on failure to do work that the CPA may not have

contemplated or agreed to do

A termination letter is a letter from a former public accounting firm (fired or resigned) to a former client specifying terms for future services and the auditors’ understanding of the circumstances of termination

4.4 Persons and skills normally assigned to a “full service” audit team:

Statistical auditing specialist, if needed

Computer auditing specialist, if needed

Industry specialist, if needed

Tax partner

4.5 Methods and sources of information for understanding a client’s business and industry:

Inquiry, including review of prior year audit documentation personnel who worked on the audit inprior years are available to convey their understanding of the business, inquiry and interviews with the company’s management, directors, and audit committee

Observation take a tour of the company’s physical facilities, keeping eyes open for activities and things that should be reflected in the accounting records The tour is the time to see company personnel in their normal workplaces

Study numerous sources AICPA industry accounting and auditing guides, specialized trade magazines and journals, registration statements and 10-K reports filed with the SEC, general

business magazines and newspapers (Business Week, Forbes, Fortune, Harvard Business Review, Barron’s, and The Wall street Journal)

4.6 Find information about real estate valuation (tax appraisal) in the city and county tax

assessor-collector files About aircraft ownership from the Federal Aviation Administration Names

of licensed doctors in the state medical society directory Assumed business names in the state or county assumed named registry Liens on personal property in the UCC documents filed, by borrower name, in the county clerk or State’s Secretary of State or commercial department office.4.7 The problem with evidence obtained from related parties is that the source is potentially biased,

and the information may be self-serving and misleading

4.8 Benefits of preliminary assessment of materiality:

Fine-tune the audit for effectiveness and efficiency

Help auditors avoid surprises related to:

Finding out too late about not auditing enough

Finding out later about auditing too much

4.9 Prior to using internal auditors, external auditors should consider internal auditors’ objectivity and competence.

4.10 The purpose of performing preliminary analytical procedures in the audit planning stage is to

direct attention to potential problem areas so the audit work can be planned to reduce the risk of

missing something important

4.11 The steps auditors can use to apply comparison and ratio analysis to unaudited financial statements

are: (1) develop an expectation, (2) define a significant difference, (3) calculate predictions and compare them with the recorded amount, (4) investigate significant differences, and (5) document each of the above steps

4.12 The ratios in Appendix 4.A are: current ratio, days’ sales in receivables, doubtful accounts ratio,

days’ sales in inventory, receivables turnover, inventory turnover, cost of goods sold ratio, return

on equity, and Altman’s financial distress ratios and discriminant score Students may be able to name other relevant ratios

4.13 Analytical procedures are required (1) at the beginning of an audit—the planning stage application

of analytical procedures discussed in this chapter and (2) at the end of an audit when the partners

in charge review the overall quality of the work and look for apparent problems They are optional as substantive audit procedures

4.14 A planning memo summarizes all the important overall planning information and documents that

the audit team is following generally accepted auditing standards The memo becomes a basis for preparing the audit program

4.15 Auditors usually prepare a planning memorandum summarizing the preliminary analytical

procedures and the materiality assessment with specific directions about the effect on the audit This planning memo also usually includes information about:

(1) Investigation or review of the prospective or continuing client relationship

(2) Provision of special services or reports and needs for special technical or industry expertise.(3) Staff assignment and timing schedules

(4) The assessed level of control risk

(5) Significant industry or company risks

(6) Computer system control environment

(7) Utilization of the company’s internal auditors

(8) Identification of unusual accounting principles problems

(9) Schedules of work periods, meeting dates with client personnel, and completion dates 4.16 General characteristics of transactions that are typically computerized: Frequent, repetitive, large

number

4.17 The “audit trail” (sometimes called “management trail” as it is used more in daily operations than

by auditors) is the source documents, journal postings and ledger account postings maintained by aclient in order to keep books These are a “trail” of the bookkeeping (transaction data processing) that allow auditors to follow the sequence of processing on (or because of) a transaction with a tracing or vouching procedures

In a manual system this “trail” is usually visible to the eye with posting references in the journal and ledger and hard-copy documents in files But in a computer system, the audit trail in

advanced systems may not be in a human-readable form and may exist for only a fraction of a second Further, the posting references may not exist, and the records must be read using the computer rather than the naked eye Most systems still have hard-copy papers for basic

documentation, but in some advanced systems even these might be absent

There are several control implications of an electronic audit trail The first implication is that concern for an audit trail needs to be recognized at the time a system is designed Techniques such

as integrated test facility, audit files and extended records must be specified to the systems designer The second control implication is that if the audit trail exists only momentarily in the form of transaction logs or master records before destructive update, the audit team must review and evaluate the transaction flow at various times throughout the processing period Alternatively,the audit team can rely more extensively on internal auditors to monitor the audit trail

4.18 The important differences between manual and computer accounting systems are in these areas:

(1) transaction trails, (2) uniform processing of transactions, (3) separation of functions, (4) potential for errors and frauds, (5) potential for increased management supervisions, and (6) initiation or subsequent execution of transactions by computer

4.19 Additional planning considerations when computer processing is involved are:

 The extent to which the computer is used in each significant accounting application

 The complexity of the computer operations used by the entity, including the use of an

outside service center

 The organizational structure of the computer processing activities

 The availability of data

 The computer-assisted audit techniques to increase the efficiency of audit procedures

 The need for specialized skills

4.20 Computer assisted audit techniques (CAATs) collectively is a set of preprogrammed editing,

operating, and output routines that can be called into use with a simple, limited set of

programming instructions by an auditor who has one or two weeks intensive training

4.21 Six audit procedures that can be performed using CAATs software are:

4.22 Advantages of using CAATs to perform recalculations are primarily speed and accuracy With

CAATS it is just as easy to recalculate all client computations as it would be to test a sample of calculations Any differences from client computations can be printed out for investigation.When using CAATs to select samples and print confirmations, the advantages include the use of preprogrammed statistical routines to randomly select the sample and the speed with which confirmations can be prepared on preprinted forms

4.23 a In the permanent audit file:

1 Copies or excerpts of the corporate or association charter, bylaws, or partnership

agreement

2 Copies or excerpts of continuing contracts such as leases, bond indentures, and

royalty agreements

3 A history of the company, its products, markets and background

4 Copies or excerpts of stockholders, directors, and committee minutes on matters

of lasting interest

5 Continuing schedules of accounts whose balances are carried forward for several

years, such as owners’ equity, retained earnings, partnership capital and the like

6 Copies of prior years’ financial statements and audit reports

b In the front of the current working paper file

1 Engagement letter

2 Staff assignments

3 Client organization chart

4 Memoranda of conferences with management

5 Memoranda of conferences with the director’s audit committee

6 Preliminary analytical review notes

7 Initial risk assessment notes

8 Initial materiality assessment notes

9 Engagement planning memorandum

10 Audit engagement time budget

11 Internal control questionnaire and control analyses

12 Management controls questionnaire

13 Computer control questionnaire

14 Internal control system flow charts

15 Audit programs

16 A working trial balance of general ledger accounts

17 Audit documentation of preliminary adjusting and reclassifying entries

18 Memoranda of review notes and unfinished procedures (all cleared by the end of

the fieldwork.) 4.24 The most important facet of the current audit documentation files is the requirement that they

show the audit decision problems and their conclusions These papers must record the proposition

to be audited, the evidence gathered, and the final decision The documentation should

demonstrate satisfaction of the standards of fieldwork and provide support for the audit report 4.25 Word processing can be used in an audit to prepare audit programs, write audit memoranda, and

write audit reports A computer electronic spreadsheet can be used instead of paper and pencil to

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

4.26 a Incorrect Confirmation is not an analytical procedure

b Incorrect Physical observation is not an analytical procedure

c Correct Analytical procedures incorporate information from a variety of

sources

d Incorrect Tests of details are not analytical procedures

4.27 a Incorrect Analytical procedures are performed after the engagement letter is

obtained

b Correct This is the “attention-directing” purpose

c Incorrect All the assertions are always important

d Incorrect This answer could be good even though it evokes the control risk

assessment standard, but restriction to inventory makes it a poor choice.4.28 a Incorrect Physical production statistics are not a source of information for

“comparison of current account balances with prior periods.”

b Correct A client’s budgets and forecasts are sources of information for

“comparison of current account balances with expected balances.”

c Incorrect Published industry ratios are not a source of information for

“evaluation of current account balances with relation to predictable historical patterns.”

d Incorrect The company’s own historical financial statements are not a good

source of information for “evaluation of current account balances in relation to nonfinancial information.”

4.29 d Correct (All of the above) Analytical procedures can be used when planning

the audit, when performing substantive procedures during an audit, and

as a method of overall review at the end of an audit

4.30 a Incorrect Weaknesses in the company’s internal control are not a subject for

preliminary analytical procedures because auditors can’t examine the internal controls at this particular time with these kinds of analyses

b Incorrect Individual transactions are not used in preliminary analytical

procedures

c Incorrect Management assertions in financial statements are not the direct object

of preliminary attention-directing analytical procedures

d Correct With preliminary analytical procedures, the auditors are looking for

signs of accounts and relationships that may represent specific potentialproblems and risks in the financial statements

4.31 a True The successor must take responsibility for obtaining the client’s consent

for the predecessor to give information about prior audits

b True Cooperation from the predecessor is expected

c True Cooperation includes obtaining copies of some or all of the predecessor

auditors’ documentation

d Correct All of the above are expected

4.32 a Incorrect Although strongly encouraged, U.S GAAS do not require a written

engagement letter for audits

b Incorrect Client consents do not have to be in writing

c Correct A written audit program is required (SAS 22, AU 311).

d Incorrect Written time budgets and schedules may be a good idea but they are not

required

4.33 a Incorrect Audit documentation is necessary to document compliance with

GAAS

b Incorrect Extracts of contracts should go in the permanent file

c Correct Independence is not really a working paper matter

d Incorrect Materiality judgments will affect the amount of evidence shown in

audit documentation

4.34 a Correct Evidence bears on the year under audit

b Incorrect Current-year evidence is usually not in the permanent file

c Incorrect The administrative audit documentation do not contain current-year

evidence about particular balances

d Incorrect The planning memo does not contain evidence

4.35 a Incorrect Internal control analysis for the current year would be in the

administrative or current file

b Incorrect The latest engagement letter would be in the administrative or current

file

c Incorrect Memoranda of conference with management would be in the

administrative or current file

d Correct Excerpts of the corporate charter and by-laws would not change often

and would be in the permanent file

4.36 a Incorrect Materiality determination helps concentrate the audit work where it is

most needed

b Incorrect Materiality determination helps auditors to do the “sufficient” amount

of work

c Correct The kind of opinion cannot be determined until all the evidence is

obtained and evaluated

d Incorrect Materiality determination helps auditors to do the “sufficient” amount

of work

4.37 a Incorrect Spreadsheet software would not be appropriate for testing internal

controls over computerized accounting applications

b Incorrect Word processing software would be best to prepare an audit program

c Correct Spreadsheet software is ideal for preparing a comparison of current

year expenses with those from the previous year

d Incorrect Word processing software would be best for drafting a planning memo.4.38 a Incorrect All CAATs are not in the same language

b Correct CAATs can be transported to various clients having various systems

c Incorrect Input controls are important in their own right

d Incorrect The use is the means to accomplish testing, but the complete set of

audit procedures can rarely be done entirely on the computer

4.39 a Incorrect These are functions of a client’s computer system.

b Correct Auditors can use the computer with ease

c Incorrect Machine operations do not leave “visible” evidence

d Incorrect Computer auditing is meant to gather good evidence with the least

quantity of storage

4.40 a Incorrect The ratio of cost/sales does not increase

b Correct The numerator (cost of goods sold) increases relatively less than the

denominator (sales) increases

c Incorrect The ratio of cost/sales does not remain unchanged

4.41 a Correct Client cooperation should be specified

b Incorrect Technical details are not in the engagement letter

c Incorrect Litigation matters are covered with respect to the request for an

attorney’s letter

d Incorrect Client representations about board minutes should be in the client’s

written representation letter

4.42 a Incorrect The auditors’ report should not mention the fact that a specialist was used,

unless the specialist’s findings affect the auditors’ conclusions

b Correct The auditors’ report should only mention the use of the specialist when

the specialist’s findings affect the auditors’ conclusions

c Incorrect The auditors’ report need not mention the use of a specialist if the

auditors decide not to take responsibility for the specialist’s findings

d Incorrect The auditors’ report should only mention the specialist if Vandalay does

not agree with the specialist’s findings, resulting in an opinion other than unqualified

4.43 a Incorrect Interviewing internal auditors about their reporting responsibilities

would assist the audit team in determining whether the internal auditorswere objective, but would provide little evidence of related-party transactions

b Incorrect Reviewing accounting records for nonrecurring transactions occurring

throughout the year would raise suspicions of fraud, but not necessarilyrelated-party transactions

c Incorrect Inspecting communications with the client’s legal counsel regarding

recorded contingent liabilities would be helpful in determining contingent liabilities

d Correct Scanning the minutes for significant transactions with members of the

Board of Directors would be helpful in identifying transactions with parties related to the client

4.44 a Incorrect A report to the audit committee on the results of testing of internal

control over cash receipts would typically occur after the entire period could be tested, and therefore would be written after the balance sheet date

b Incorrect Confirmation letters to vendors confirming the amounts they owe to the

client are part of substantive procedures performed on balance sheet account amounts

c Incorrect An attorney’s letter regarding contingent liabilities would be written as

close to the end of fieldwork as practicable

d Correct An engagement letter would be written before accepting an

engagement, and therefore before the balance sheet date

4.45 a Incorrect Surprise counts of the client’s petty cash fund may occur during

planning, but are more typically performed close to the balance sheet date

b Incorrect Reporting internal control deficiencies to the audit committee would

typically occur after internal control testing was complete

c Incorrect Performing a search for unrecorded liabilities would be performed as a

substantive procedure after planning

d Correct Identifying related parties is an important part of planning

4.46 d Correct Prior to accepting a new audit engagement, an audit firm should (a)

attempt to contact the predecessor auditor, (b) evaluate the integrity of management, and (c) assess the firm’s resources

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS

4.47 Analytical Procedures

Majestic appears to be:

1 A large hotel (200 rooms versus 148)

2 that charges slightly more than the average rate ($160 versus $120)

3 and does not promote room occupancy too heavily (2.7% advertising versus 3.2%)

4 hence its occupancy paying guests is not especially high (62.6% versus 68.1%),

although this occupancy rate represents more average rooms per day (125 = 62.6% x 200)than the industry (101 = 68.1% x 148)

Majestic also appears to:

1 Derive relatively more revenue from food and beverages (35.7%) than the industry

(32.3%)

2 Be more lavish in providing food and beverages

 Cost of food sold (42.1% versus 37.0%)

 Cost of beverages sold (43.6% versus 29.5%)

Majestic HotelPreliminary Program MemorandumAnalysis of StatisticsFYE 3/31/09Analysis of the operating statistics in working paper AP-6 indicates that the following may be indicative of areas in the accounts where potential errors or frauds or other matters of audit concern may exist These should be covered in our preliminary planning of the audit program

1 Room sales revenue is not up to the industry average ratio Revenues may not be

recorded properly either not recorded or misclassified as food and beverage sales

2 Management fees appear considerably higher than the industry average Expenses may

be misclassified or a related party transaction may be involved

3 Utilities, repairs, and maintenance appear to be higher than the industry average Some

capitalizable expenditures may have been improperly classified as current expenses

4 Salaries and wages in both the rooms department and the food and beverages department

appear to be high The problem may be more employees than average, padded payrolls,

or wage rates higher than average

5 The cost of food and beverages sold appears to be much higher than the industry average

This could be due to payment of higher unit prices (presumably for higher quality), use ofgreater quantities per serving, inventory pilferage, or erroneous inventory counts and pricing

4.48 Audit Simulation: Preliminary Analytical Procedures

E X H I B I T 4.48–2ALPHA.COM, INC

PRELIMINARY ANALYTICAL PROCEDURES DATACOMPARATIVE, COMMONSIZE FINANCIAL STATEMENTS

Prior Year

Balance CommonSize Balance CommonSize Amount PercentChangeREVENUE

Selected Financial Ratios

Financial Distress Ratios (Altman)

4.48 Audit Simulation: Preliminary Analytical Procedures (Continued)

Current(Unaudited)

PotentialError

Current asAffected (?)REVENUE AND EXPENSE:

($ 84,000) 18,000( 4,000)

$2,636,000 2,021,000 330,000Operating income

Interest expense

Income taxes (40%)

$ 383,000 75,000 123,200

($ 98,000) 35,000( 53,200)

$ 285,000 110,000 70,000

$ 0( 300,000) 0 216,000 53,200

$ 690,800 600,000 (90,000) 1,566,000 53,200Total current assets

Fixed assets

Accumulated depreciation

$2,850,000 4,500,000(1,834,000)

($ 30,800) 0 4,000

$2,820,000 4,500,000(1,830,000)

$ 0 0 35,000 18,000

$ 330,000 1,750,000 75,000 50,000Total current liabilities

Long-term debt, 10%

$2,152,000 400,000

$ 53,000 0

$2,205,000 400,000TOTAL LIABILITIES

Capital stock

Retained earnings

$2,552,000 2,000,000 964,800

$ 53,000 0 (79,800)

$2,605,000 2,000,000 885,000

4.48 Audit Simulation: Preliminary Analytical Procedures (Continued)

SOLUTION EXPLANATION:

Many of the conclusions are based on the prior year being the best indicator of current year

“accurate” figures

1 Sales and Accounts Receivable may be overstated $300,000 ALPHA.COM, INC.’s

“more liberal return privileges” may have caused early recording of sales and receivables

A $300,000 error will bring the accounts receivable back near the prior year gross total

2 If $300,000 sales were recorded too early, the related Cost of Goods Sold should be

restored to Inventory Apparently the COGS is 72 percent of sales The adjustment could

be $216,000 HOWEVER, if the proper COGS ratio is approximately 70% as in the prior year instead of 72%, the COGS may be overstated (and the inventory understated) by another $188,400 (2% x $9,420,000)

3 The Allowance for Bad Debts may need to be higher than the prior year because of credit

and return terms Leave it at $90,000 on $600,000 receivables, although this 15 percent ratio is much higher than the prior year (8%) HOWEVER, if eight percent is the more appropriate ratio, the allowance (and bad debt expense) may be overstated by $42,000 (7% x $600,000)

4 Expense accruals might have been omitted in the amount of $18,000, which would bring

the accrued expenses up to the prior year amount ($50,000)

5 Depreciation expense appears to have been calculated on the basis of the planned capital

addition of $1,700,000 instead of the actual recorded amount of $1,500,000 ($1,500,000 for 25 years, 1/2 year, no salvage is $30,000 in addition to the prior year $300,000.)

6 The bank loan interest accrual for the 4th quarter ($35,000 = $1,750,000 x 08 x 1/4 year)

appears to have been overlooked Interest expense for the six months should be $70,000 ($1,750,000 x 08 x 1/2 year) plus the $40,000 on the long term debt, for a total of

$110,000 instead of $75,000

7 The income-reducing potential errors have a tax effect (40%) of $53,200 Since

ALPHA.COM, INC apparently paid the taxes based on the unaudited income, a tax refund receivable will arise with the final tax return

Although the problem information is not explicit, ALPHA.COM, INC apparently paid dividends

of $120,000 (same as prior year) If this is not the case, a $120,000 unexplained debit is buried in the retained earnings account If it is not a dividend, it might be a misclassified loss or a prior period adjustment

4.49 Analytical Procedures — Ratio Relationships

a The current ratio was made larger than it should have been The current asset numerator

was made larger (fictitious accounts receivable larger than the inventory removed) while the current liability denominator did not change (However, if the income tax effect of the error is included, the current liabilities change by a greater proportion that the current assets change, and it turns out that the current ratio was made smaller !)

b In this case the relative rate of change is important, because both the numerator and

denominator of the current ratio are changed by the same amount

1 Current ratio (before) was greater than 1:1 the incorrect accounting makes the

ratio larger than it should be

Example: Before $100,000 / $20,000 = 5.0:1After $ 90,000 / $10,000 = 9.0:1

2 Current ratio (before) was equal to 1:1 the incorrect accounting does not

change the ratio

Example: Before $100,000 / $100,000 = 1:1After $ 90,000 / $ 90,000 = 1:1

3 Current ratio (before) was less than 1:1 the incorrect accounting makes the ratio

smaller than it should be

Example: Before $ 20,000 / $100,000 = 0.2:1After $ 10,000 / $ 90,000 = 0.11:1

c Effect of unrecorded purchase counted in physical inventory, assuming the accounts are

adjusted to include the inventory on hand

Inventory is not misstated

Cost of goods sold is understated

Gross profit is overstated

Net income is overstated

The effect on the ratios compared to what they would have been without the error:Current ratio:

Greater than 1:1 before The error of recording the inventory and not

the current payable makes the ratio larger.Equal to 1:1 before The error makes the ratio larger

Less than 1:1 before The error makes the ratio larger

Gross margin ratio: The error makes it larger

Cost of goods sold ratio: The error makes it smaller

Receivables turnover: The error does not affect either the sales

numerator or the receivables denominator,

so the ratio is not affected

4.49 Analytical Procedures — Ratio Relationships (Continued)

d In this case the net receivables amount is correct The proper adjustment should be to

reduce gross receivables and the allowance for doubtful accounts by an equal amount.Current ratio: Not affected because the current asset and current liability totals are not

affected

Day’s sales in receivables: Not affected when the net receivables is used to calculate the

ratio

Doubtful account ratio: The improper accounting causes the ratio to be larger than it

should be (Proper accounting would cause the allowance numerator to be reduced to a greater extent, by a faster rate, than the receivables denominator.)

Receivables turnover: Not affected when the net receivables is used to calculate the

ratio

Return on beginning equity: Not affected because the income is measured

properly with adequate allowance for doubtful accounts

Working capital/Total assets: Not affected because both terms are measured

properly

e The effect on the Altman (1968) discriminate Z score is a larger score because of the

directional effect of all the changes mentioned:

Working capital/Total assets: The ratio is larger because WC is greater and TA is

smaller

Retained earnings/Total assets: The ratio is larger because retained earnings

remained the same while TA is smaller

Earnings BIT/Total assets: The ratio is larger, because EBIT is about the same as

last year, and TA is smaller

Market equity/ Total debt: The ratio is larger because market equity is the same,

while total debt is lower

Net sales/Total assets: The ratio is larger because net sales have decreased less (5%)

than the total assets have decreased (10%)

4.50 Audit Documentation

a 1 The functions of audit documentation are to aid the CPA in the conduct of his

work and to provide support for his opinion and his compliance with auditing standards

2 Audit documentation is the auditors’ record of the procedures performed, and

conclusions reached in the audit

b The factors that affect the auditors’ judgment of the type and content of the audit

documentation for a particular engagement include:

1 The nature of the auditors’ report

2 The nature of the client’s business

3 The nature of the financial statements, schedules or other information upon

which the auditors are reporting and the materiality of the items included therein

4 The nature and condition of the client’s records and internal controls

5 The needs for supervision and review of work performed by assistants

c Evidence which should be included in audit documentation to support auditors’

compliance with generally accepted auditing standards includes:

1 Evidence that the financial statements or other information upon which the

auditors are reporting were in agreement or reconciled with the client’s records

2 Evidence that the client’s system of internal control was reviewed and evaluated

to determine the nature, timing, and extent of audit procedures

3 Evidence of the audit procedures performed in obtaining audit evidence for

evaluation

4 Evidence of how exceptions and unusual matters disclosed by audit procedures

were resolved or treated

5 Evidence of the auditors’ conclusions on significant aspects of the engagement

with appropriate commentaries

d The audit team should perform an adequate examination at minimum cost and effort and

the preceding year’s programs will aid in doing this The preceding year’s audit programs ordinarily contain information useful in the current examination (such as descriptions of the unique features of a client’s operations or records, a formalized sequence of audit steps in logical order, and approximate time requirements to perform various phases of the work.) The audit team should decide whether to use the old program or prepare a new one

4.51 Analytical Procedures and Interest Expense

a The audit estimate of interest expense for these notes is about $ 24,400

Notes Payable Balances Auditors’ Interest CalculationDate Balance Rate Time Interest

Calculated on Average Balance and Average Rate $24,432

b The type of analytical procedure is “study of the relationships of current-year account

balances with relevant nonfinancial information.” While the interest rate may not seen to

be an item of “nonfinancial information,” it is not a direct entry or element in the client’s financial statements Anyway, three of the other four types of analytical procedures do not describe the estimate (because it does not compare to prior periods, compare to budget, or compare to industry information) However, a case might be made that the estimate is an “evaluation of a relationship of current-year account balances (notes payable) to other current-year balances (related interest expense) for conformity with a predictable pattern (interest rate relation) based on the company’s experience

c The recorded interest expense appears to be too small The company may have forgotten

or miscalculated the year-end interest expense accrual (In fact this amount was specifiedbecause the missing amount is approximately the $750 of the accrual for the December interest.)

d The recorded interest expense is about right Some differences in timing and calculation

might explain the small difference, but it is not material enough to warrant further work

e The recorded interest expense appears to be too large Maybe the company has other

debt on which interest is being paid, but the debt is not recorded in the accounts (In fact this amount was specified in terms of an extra $100,000 being borrowed in July at 9.5% interest, not recorded, but paid back by August 1 before the next recorded borrowing This would account for about $800 additional interest: $100,000 x 9.5% x 1/12 = $792.) Could be that Weyman found he could borrow the company’s cash for himself, earn